S&P Downgrade: The Real Risk Is in Europe, Not the U.S.

Last Updated Aug 8, 2011 2:51 PM EDT

Standard & Poor's move to snip America's credit rating could cause chaos -- not in the U.S, mind you, but in Europe.

Here at home, bondholders are keeping their nerve today following the credit rating agency's downgrade last week of U.S. debt from AAA to AA+. While stock markets are tumbling, money is pouring into Treasury bonds. Here's what that suggests:
  • Investors have been expecting the credit hit for months
  • Whatever S&P's opinion about the impact of political strife on the U.S. economy, this country's ability to pay its debts remains unquestioned
  • U.S. sovereign debt is still a safe haven compared with other financial assets
Says one market analyst:
"It just shows that the financial markets have concluded on their own that U.S. Treasurys are the highest credit quality bonds that are available," said Jim DeMasi, chief fixed income strategist at Stifel Nicolaus in Baltimore. "There's no substitute for the safety, liquidity and basically the quality of U.S. Treasurys. That's the market's conclusion. S&P has a different view of that and it hasn't changed market perceptions in any way."
Europe is another story. Now that S&P has lowered America's credit rating, the firm may also drop the hammer on other countries with top credit ratings struggling to reduce their debt. Like France, for instance, where the price of insurance against default is surging.

As hedge fund manager Niels Jensen notes, downgrading French debt would damage the credit of large French banks. More specifically, it would increase their borrowing costs even as they face pressure to raise capital to offset possible losses in Greece and make it more difficult to refinance their existing debt.

Other eurzone countries that could be ripe for a downgrade are Belgium and Spain, both already in the credit raters' doghouse. Some prominent investors even think the U.K. could eventually see its credit rating reduced. That's notable because investors had until recently taken comfort in Britain's push under Prime Minister David Cameron to slash government spending. But the country's slow growth this year is raising questions about the wisdom of austerity.

Europe's problems would be difficult to solve in the best of times. As the global economy cools, they seem increasingly intractable because any solution assumes that Greece, Portugal and other weaker economies in the region will eventually grow their way out of debt. A ratings downgrade in "core" eurozone countries like France wouldn't change that fundamental challenge, but it certainly wouldn't make it any easier.

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  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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